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TaxationWeb by Malcolm Finney

Malcolm Finney looks at the layout and method of computing an individual’s income tax liability.

Pro-forma

The key to performing a personal income tax calculation for an individual lies in adopting the correct format.

The following format should be adopted;

   

                                                     Non-Savings       Savings             Dividend  

                                                       Income          Income               Income



Income 



Less: Charges on income



STI (Statutory Total Income)



Less: Personal allowance



Taxable income

Having then worked out the Taxable Income for each category of income (ie Non-savings, Savings and Dividend income) the income tax liability
can then be worked out as follows.

Income tax liability on:

Non-savings income
Savings income
Dividends

Total income tax on all income
Plus: Basic rate tax withheld on charges on income

Income tax liability

Less: Income tax suffered at source on following income:
Tax credit on UK dividends
PAYE on salary
Tax on bank deposit interest
Tax on building society deposit interest

Income tax payable

Some important points to note

• Note that there is a difference between 'Income tax liability' and 'Income tax payable. The former refers to the total income tax liability
of the individual before any account is taken of income which may have been received after having had tax at source deducted from it.
Tax deducted at source represents a partial payment by the individual on account of his/her ultimate income tax liability. Having
worked out the income tax liability any tax deducted at source is then simply deducted to arrive at the net income tax payable.

• Income is included in the pro-forma “gross” ie interest received net (ie after deduction of 20% income tax) needs to be “grossed up” for tax deducted;
any net dividends received must be included with the attaching tax credit (equal to 1/9th of the net dividend); and salary should be included
before tax deducted at source (ie before the levying of PAYE)

• Whilst bank and building society interest is received “net” and thus needs grossing up, interest on National Savings Bank (NSB) deposits does not need
grossing up as it is received gross. Note, also, that the first £70 on a NSB ordinary deposit account is tax free; only the excess is taxed. Interest on
a NSB investment account is taxed with no £70 exemption and, as indicated above, is received gross.

• Tax free income would include interest/dividends on ISAs; interest on National Savings Certificates; and gambling winnings.

• Non-savings income is taxed first followed by Savings income followed by Dividend income (ie dividend income is treated as the top slice
of taxable income). For tax year 2005/06:

• for Non-savings income the first £2,090 of Taxable Income is taxed at 10%; the next £30,310 is taxed at 22% and everything above £32,400 is taxed at 40%

• for Savings income which is taxed after Non-savings income (ie on top of it) any amount falling in the first £2,090 is taxed at 10%; any Savings income
which falls in the next £30,310 is taxed at 20% and any such income in excess of £32,400 is taxed at 40%

• for Dividend income which is taxed after both Non-savings and Savings income (ie on top of both) any Dividend income falling in the amount up to £32,400
is taxed at 10% and above £32,400 is taxed at 32.5%.

Example 1 - John Smith has Taxable Income as follows:

£25,000 Non-savings income
£4,000 Savings income (net)
£2,250 Dividend income (net)

John’s income tax liability is computed as follows:

First - ensure that all income of John has been grossed up if any income tax at source has been deducted before John received it:

Non-savings income = £25,000 (no grossing up necessary)
Savings income = £4,000/0.80 = £5,000 (grossing up necessary)
Dividend income = [£2,250 + 1/9 x £2,250] = £2,500 (grossing up necessary)

Second - compute income tax liability on each category of income starting with Non-savings income, then Savings and finally Dividend income:

Non-savings income
First £2,090 of Non-savings income taxed at
10% x £2,090 = £209

Next (£25,000 - £2,090) of Non-savings income taxed at
22% x £22,910 = £5,040

Savings income
Next £5,000 of Savings income taxed at
20% x £5,000 = £1,000

(this is because the total of Non-savings income of £25,000 plus Savings income £5,000 ie £30,000 is still below the £32,400 level at which the rates change)

Dividend income
Next £1,400 of Dividend income taxed at
10% x £2,400 = £240
(ie £32,400 less £30,000 of Non-savings and Savings income above already taxed)

Next £100 of Dividend income (making £2,500 of dividends) taxed at
32.5% x £100 = £33
(ie balance of Dividend income of £2,500 minus £2,400)

TOTAL INCOME TAX LIABILITY = £209 + £5,040 +£1,000 + £240 + £33 = £6,522

As can be seen, in working out an individual’s income tax liability each category of income (ie Non-savings, Savings and Dividend) is added to those categories
already taxed and then taxed. Thus, it will be noted that there is only one amount of £2,090 taxed at 10%. Each category of income is not entitled
to its own amount of £2,090.

Now an example adopting the pro-forma set out above:

Example 2

John Smith is aged 42 and is not married.
He has the following income and payments for the tax year 2005/06:

Salary £32,000 (gross; PAYE deducted of £2,500)
Bank interest £2,400 (net)
Building society interest £800 (net)
Dividends on UK shares £3,600 (net)
Charges on income (patent royalty payments) £2,000 (gross)

JOHN SMITH: INCOME TAX COMPUTATION 2005/06

						

                                    Non-       Savings         Dividend       Total  			 

                                  savings      income           income

                                  income			

	                            £		 £                £             £

Income from employment	          32,000						

Building society interest			1,000				

Bank interest			                3,000				

UK dividends	 		                                4,000		

                                 _______       ______          ______   	

                                  32,000        4,000		4,000		

Less: Charges on income           (2,000)		 		 		

                                 _______

Statutory total income (STI)	  30,000        4,000           4,000		

Less Personal allowance           (4,895)						

                                 _______       ______          ______

Taxable income	                  25,105        4,000		4,000		

                                 _______       ______          ______							



Income tax                                                       £              £



Non savings income							

£ 2,090 x 10%                                                                  209

£23,015 x 22%                                                                5,063

_______                                                                      _____

£25,105                                                                      5,272



Savings (exc. Dividend) income							

£4,000 x 20%                                                                   800

_______

£29,105							



Dividend income							

£3,295 x 10%								       330

_______

£32,400							

£   705 x 32.5%                                                                229

_______									     _____											

£33,105                                                                      6,631



Add basic rate tax withheld on charges on income							

Paid net £2,000 x 22%                                                          440

							                     _____

Tax liability                                                                7,071



Less tax suffered							

PAYE tax on salary (say)					2,500		

Tax on building society interest                                  200		

Tax credit on bank interest                                       600		

Tax credit on dividend income                                     400		

						               ______	    (3,700)

							  	            ______	

										

Tax payable                                                                  3,371

                                                                            ______  

With respect to the above computation note the following:

• the building society and bank interest received were 800 and 2,400 respectively. They have each been grossed up by dividing by 0.8 to take account
of the 20% tax withheld at source.

• the net dividends received were 3,600.These have been grossed by including the tax credit of 1/9th of the net dividend received.

• the charges on income and the personal allowance have each been deducted from the Non-savings income column. This minimises tax payable.
If Non-savings income had been insufficient then the excess charges/allowance would have then been deducted from Savings income then Dividend income.

• the tax deducted at the basic rate of 22% by John Smith on making the charge on income payment needs to be added back in working out his Income tax liability
as the gross charge has already been deducted higher in the pro-forma. Otherwise, without the add-back John would obtain tax relief twice.
Note also where in the pro-forma the tax was added back.

• John Smith is entitled is entitled to the normal £4,895 personal allowance.


March 2006

Malcolm Finney M.Sc (Bus Admin) M.Sc (Org Psych) B.Sc MCMI C Maths MIMA


Malcolm is an international tax and management consultant. He was formerly head of tax at the london law firm Nabarro Nathanson and at the international
accountancy firm Grant Thornton. He also currently lectures at one of London's leading accountancy colleges and is a visiting lecturer in taxation at the
University of Greenwich. His latest book "UK Taxation for Students: a Simplified Approach" is available from www.spiramus.com and is suitable
for anyone studying for tax examinations in 2006.